On June 3, 2020, we liquidated our remaining position in Raytheon Technologies Corporation (Raytheon), one of the largest aerospace and defense companies in the world with estimated 2020 sales of approximately $63 billion. Raytheon was formed on April 3, 2020 via the merger of Raytheon Company and United Technologies Corporation (UTX), a long-time portfolio holding. Immediately prior to the merger, UTX spun-off its elevator and escalator business, Otis Worldwide Corporation (Otis), as well as its heating, ventilation and air conditioning (HVAC) business, Carrier Global Corporation (Carrier).
Prior to the spin-offs and subsequent merger with Raytheon Company, UTX was a well-diversified industrial conglomerate with operations in commercial aerospace, defense and the previously mentioned HVAC and elevator and escalator businesses. At that time, the company’s market positions were strong, it generated significant amounts of free cash flow and sported a strong balance sheet. Competitive advantages for UTX included its entrenched market positions and its ability to produce highly sophisticated, technologically-advanced products. The company’s manufacturing footprint represented a significant barrier to entry as it would have been expensive and time consuming for potential new entrants to replicate that footprint. We expected urbanization and rising incomes in emerging markets, on-going cost reductions and the robust commercial aircraft order backlogs at Airbus and Boeing to drive UTX’s revenues and profitability well into the future. For these and other reasons, we believed UTX was a high-quality company worthy of inclusion in the portfolio.
Despite these positives, a combination of events resulted in our liquidation of the name. The spin-offs of Otis and Carrier reduced diversification, resulting in a company focused primarily on commercial aerospace and defense. In addition, the COVID-19 pandemic negatively impacted business and leisure air travel and is expected to materially lower airline profitability and cash flows. With fewer customers and weakened finances, we believe airlines’ demand for new aircraft will fall meaningfully, causing the backlogs at Airbus and Boeing to decline. This should lower production, pressuring Raytheon’s commercial aerospace sales. Finally, we believe the company will most likely violate our longstanding 15% ROE hurdle at the end of this year due to the previously mentioned merger. From an accounting standpoint, UTX was considered the acquiror in the merger. Generally Accepted Accounting Principles require the assets, liabilities and equity of a business to be marked to fair value if it is acquired. This accounting rule resulted in a significant increase in Raytheon Company’s equity. When combined with UTX’s equity, we expect the increase to result in an ROE below 15%.
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